Interest Rates

Thursday 18 November, 2008

Wholesale interest rates have declined further this week in response to increasing expectations for the size of the Reserve Bank's next cut in interest rates and the potential for further interest rate falls beyond December 4. Over the past week we have seen the IMF drastically cut their forecasts for growth in the world economy and some relatively downbeat comments about growth in the Australian economy by the Reserve Bank of Australia. This latter factor has increased expectations about the size of the next cut by the RBA on December 2 - which becomes relevant to what happens here.

There is a view that following a 0.75% cut two weeks ago the RBA will cut another 0.75% on December 2. This would add up to considerable pressure on our own central bank to ease a lot two days later.

The chances are increasing that we will see at least a 0.75% cut in New Zealand's cash rate on December 4 especially with some extra downward pressure on inflation over the short term from continuing declines in petrol prices. Note however that these will be offset to some extent by increasing evidence of the falling New Zealand dollar leading to higher prices for things such as new motor vehicles and some whitewear items.

The two-year swap rate has ended the week near 5.75% compared with 6.1% a week ago and 6.5% four weeks ago. In the old days this sort of decline in a short time period would have led us to say people should expect fixed interest rates to decline maybe 0.25% in the next week or two. This was because there was a relatively stable relationship between the swap rates we can write about here and offshore wholesale borrowing costs which are generally not visible in any data series. This is because offshore funding largely involves one-off deals in a variety of countries with different maturities and from different organisations.

In fact if we were still living in the pre-credit crisis times and it had been general weakness in the economy which had produced a near 5.8% two-year swap rate we would expect to see two-year fixed housing rates sitting around about 6.5%. This is because over the past five years the average gap between the two-year swap rate and the two-year fixed housing rate has been approximately 0.7%.

The same comments apply to the 90 day bank bill yield. There used to be a reasonably stable relationship between this interest rate, the official cash rate underneath it, and floating mortgage rates usually about 2% above it. The 90 day bank bill yield has fallen to near 6.4% this week from 7% last week and 7.6% a month ago. One might think a 6.4% bill yield would lead relatively soon to floating rates near 8.4%. But again increased funding costs overseas mean the old margin between this wholesale interest rate and floating mortgage rates no longer applies. In addition it has to be remembered that the mortgage battlefield in New Zealand does not involve floating mortgage rates. Traditionally fixed interest rates in New Zealand have been lower than floating rates since they first appeared in the 1990s. This is for at least two reasons. One is that the yield curve in New Zealand is commonly inverse with short-term wholesale rates above long-term wholesale interest rates. (Not at the moment.)

The other reason however is that when fixed interest rates appeared during the early 1990s new entrants to the banking sector appeared. They chose to compete for business by discounting fixed interest rates. Existing banks responded by also discounting fixed interest rates rather than cutting floating interest rates.

This is because if a floating interest rate is cut it means reduced returns not only from new customers but also existing ones. While the proportion of mortgage volume sitting at floating interest rates is now around only 15% old habits remain.

Our current expectation is that we will see the Reserve Bank continue to cut the official cash rate down to approximate 5% in the middle of next year. If the world economy continues to deteriorate at a rapid pace they will take the rate even lower. But keep an eye out for what may happen over 2010. New Zealand's economy is going to handle the global recession better than many others and over 2010 we are likely to see an export led upturn which could spread quite quickly into the domestic economy. That means the Reserve Bank could look to increase interest rates again relatively quickly over 2010.

But as we have been doing for a long time now we have to emphasise the massive level of uncertainty about where things are going to go in this current virtually unprecedented environment.

Key Forecasts

• Monetary policy easing with the official cash rate near 5.0% come mid 2009.
• The two year fixed housing rate reaching 7.5% in mid-2009 or earlier, with further downside after that assuming easing of the credit crisis. Falling to the 6.5% low of 1999, 2001 and 2003 is unlikely this cycle.

If I Were a Borrower What Would I Do?

Given strong potential for falls in mortgage interest rates I go floating at the moment and take the relative pain of the floating interest rate in the short term but the potential for a lower fixed rate further out. Fixed interest rates are likely to keep falling until somewhere perhaps in the second half of next year and that is probably when one would want to have a look at fixing for one of the longer terms.

Source: Tony Alexander, Chief Economist of the Bank of New Zealand.